Net Phones Start Ringing Up Customers

Big rollouts by cable operators have the Baby Bells scrambling to fight back

For years, the tech industry has held out grand hopes for transforming today's aging phone systems into Web-based providers of inexpensive digital phone service -- with a myriad of dazzling features to boot. Now, communications companies are close to making good on those promises. On Dec. 8, cable giant Time Warner Inc. (TWX ) announced that it will team up with long-distance providers MCI and Sprint (FON ) to roll out Internet-based phone service for its 11 million cable-TV customers by the end of 2004.

Three days later, AT&T (T ) weighed in, saying it will also offer Internet-based phone service in as many as 100 of its markets. Local phone giants Verizon Communications (VZ ), SBC Communications, and Qwest Communications International, too, plan to deploy the new technology, called "voice over Internet Protocol" (VOIP) in their consumer phone services starting next year. "The pressure has been building over time," says Charles H. Giancarlo, senior vice-president at equipment maker Cisco Systems Inc. (CSCO ). "It's not getting released slowly. It's exploding."

That's no overstatement. The upheaval wrought by the race of both cable companies and telcos to harness the Internet for digital voice communications promises to be monumental. Battle lines are emerging. On the defensive are the Baby Bells, which have long enjoyed dominance in the lucrative local phone service. Rising up to snatch a piece of their prized core market are cable companies and, now, AT&T.

The Bells could be in for a rough patch as the competition heats up. Because the technology allows phone calls to ride on telecom networks as so-called "data packets," they're able to sidestep older phone systems. That makes phone calls as cheap to transmit as e-mails. VOIP also will allow competitors like Time-Warner and AT&T to reach consumers without paying hefty access charges to local carriers. What's more, such providers could get a break from taxes now imposed on local carriers.

Fueling the push for VOIP is the spread of affordable broadband: Any home with either a cable modem or a telephone digital subscriber line (DSL) is ready for VOIP. And a VOIP line can be established for just 10% to 20% of the cost of deploying a regular phone line, says Cisco's Giancarlo. Goldman, Sachs & Co. (GS ) says new broadband subscribers jumped 18.2% in the third quarter over the previous year. As more carriers roll out telephone service, the number of Internet-based phone lines could grow from well under a million subscribers in 2002 to more than 5 million by the end of next year, according to Boston management consultant Adventis Corp. To lure all those customers, cable and telcos are likely to engage in intense competition, each offering consumers a "triple play" of voice, Net access, and TV, all on one bill.

CORPORATE CALLS. For now, at least, cable companies are in the driver's seat. Roughly 21 million U.S. homes connect to the Net via high-speed connection. But two-thirds of them use cable modems, while the rest rely mostly on DSL. And cable leaders such as Time Warner, Cox Communications (COX ), and Comcast Holdings (CMCSK ) are ahead of the phone giants in offering triple-play bundles. Time Warner's decision to expand its digital phone offering into all its markets followed a successful launch in Portland, Me., where 18% of its cable-modem customers now pay $40 a month for unlimited local and long-distance calling. Similarly, AT&T, faced with falling long-distance revenues, plans to let its customers tap into its nationwide network via broadband connections.

The Baby Bells aren't sitting still. Some are cutting their teeth by running VOIP phone systems for corporate customers; SBC introduced the service in 30 states in November. That could be a big market. Merrill Lynch & Co. (MER ) and software-maker Sybase Inc. use VOIP gear to handle calls among employees, saving millions in phone charges. This $2 billion market is expected to grow at over 20% a year, and carriers are racing to meld basic phone service with new data-related offerings. When a child goes missing in Herndon, Va., for example, the town's new system will automatically show a picture of the child and possible suspects to special screen-equipped VOIP phones used by all municipal workers.

Meantime, low-priced offers from carriers, including SBC, Verizon, and BellSouth (BLS ), are snaring millions of new DSL customers -- most of whom will be able to use the service to make telephone calls by the end of next year. Verizon plans to make the service available to residential customers next month. Qwest hopes to offer it in all its 14 states by the end of 2004. A host of innovative smaller phone companies are already setting a good example: SureWest Communications (SURW ) in Roseville, Calif., began rolling out a triple-play offer 18 months ago. Of the 10,000 homes that are now eligible, 5,000 have signed up.

A SURGE FOR SUPPLIERS. All this is good news for VOIP gear makers, such as Cisco and a host of small startups, that sell Net-style equipment. U.S. carriers will spend about $1.6 billion on VOIP gear in 2003, up about 10% from 2002, according to telecom-gear analyst Steve Levy of Lehman Brothers Inc. (LEH ). That's much healthier than the overall telecom-gear market, which he estimates will decline 20% in 2003, to $55 billion.

Then again, don't count out the Old Guard equipment suppliers just yet. In recent months, they've unveiled products and services to help carriers fold VOIP capabilities into their existing phone networks. That way, carriers won't have to throw out existing gear or take a chance on new, untested suppliers. "There isn't any question that the world is moving to [VOIP], and we intend to take advantage of it as well," says Malcolm Collins, president of Nortel Networks Corp.'s (NT ) enterprise-networks unit. Now that everyone agrees, it's time to see who can deliver.

By Peter Burrows in San Mateo, Calif., and Roger O. Crockett in Chicago, with Steve Rosenbush in New York and Charles Haddad in Atlanta

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